CFA 2018 level 3 schweser practice exam CFA 2018 level 3 question bank CFA 2018 r07 behavioral finance and investment processes summary

Level III Behavioral Finance and Investment Processes Summary Graphs, charts, tables, examples, and figures are copyright 2014, CFA Institute Reproduced and republished with permission from CFA Institute All rights reserved Uses and Limitations of Classifying Investors into Types Investors can be classified by their psychographic profile i.e behavior, personality, attitudes and interests BB&K (Bailard, Biehl and Kieser) model classifies investors into five types based on two axes of “investor psychology” Hint: selfemployed Confident Individualist • make decisions after careful analysis • listen to advice • process information in a rational manner • high risk tolerance • prefer to maintain control over investments • reluctant to take advice • hold highly undiversified portfolios Straight Arrow Careful Guardian Hint: Retired or near to retire people Adventurer • prefer to seek advice • avoid volatility • seek preservation of wealth Impetuous Celebrity • prefer following popular investments • willing to take investment advice rational, balanced, secure and sensible Anxious www.ift.world Behavioral Alpha Process A top-down approach to bias-identification Interview client to identify active or passive traits and risk tolerance Plot investor on active/passive scale and risk tolerance scale  Active investors: medium to high risk  Passive investors: low risk • • • • • • • Test for behavioral biases to identify behavioral biases in a client Active Investor Traits Earned wealth by risking own money (e.g entrepreneur) Maintain control over investment decisions Have faith in own abilities Prefer risky asset allocation Aim for maximization of wealth by foregoing current lifestyle Take initiative Not reluctant to borrow money Opposite will be true for passive investor Classify investor into a behavioral investment type (BIT) to identify biases If an investor is classified as active investor in Step but he exhibits low risk tolerance in Step 2, then assume he/she is a passive investor www.ift.world Behavioral Investor Type Diagnostic Process How Behavioral Factors Affect Client-Adviser Relations Understanding client’s behavioral tendencies allows advisors to: • better formulate financial goals • better understand the client before delivering any investment advice • formulate an appropriate asset allocation for the client • develop a stronger bond by satisfying clients Limitations of Classifying Investors An individual may: • exhibit both cognitive and emotional biases at the same time • reflect characteristics of multiple investor types • exhibit changing behavior over time • need unique treatment • act irrationally and in an unpredictable manner www.ift.world Biases Associated with Each Behavioral Investor Type (BIT) Basic type Passive Passive Active Active Low Low to medium Medium to high High Conservative Moderate Growth Aggressive Emotional Cognitive Cognitive Emotional BIT Passive Preserver • dislike losses • dislike change • uneasy during times of stress • probably became wealthy passively (through inheritance) • under-react to new information Friendly Follower • follow others • invest in popular investments • believe that their forecasts about future events were more accurate than they actually were • respond differently based how questions are framed • overestimate risk tolerance Independent Individualist • overestimate ability to predict • maintain views on market • under-react to new information • not get corroboration from other sources • place higher weight to information which is readily available • make decisions based on personal classification Emotional biases • • • • • regret aversion • overconfidence & self-attribution Cognitive biases • mental accounting • anchoring and adjustment • availability • hindsight • framing • • • • Investment advice • difficult to advise • explain effects of investment decisions on various investment goals • may listen to advice • advisors should provide quantitative measures • may listen to advice • advisors should provide quantitative measures Risk tolerance Investment style Primary bias loss aversion status-quo endowment regret aversion www.ift.world conservatism confirmation availability representativeness Active Accumulator • entrepreneurial • exhibit over-confidence in their ability to predict or succeed • not save for future • actively involved in decision-making  trade excessively • overconfidence • self-control • illusion of control • most difficult to advise • explain effects of investment decisions on various investment goals Impact of Behavioral Factors on Portfolio Construction Behavioral Factors/Biases Impact on Portfolio Construction Status quo bias Sticking with default portfolio allocation despite changes in risk tolerance level or other circumstances Regret aversion and framing biases Naïve diversification or 1/n strategy: allocating an equal amount of money to available investment options regardless of the different risk profiles of these options Overconfidence, representativeness & availability, status-quo, framing, endowment biases Investing in the familiar: a classic example is being overweight in own-company stock Regret aversion, overconfidence, and disposition effect (loss aversion) biases Excessive trading which results in high transaction costs and poor portfolio performance Availability, illusion of control, endowment, familiarity, and status quo biases Investors invest a relatively high portion of their funds in domestic stocks Home bias www.ift.world Impact of Behavioral Factors on Analysts Behavioral Factors Biases Remedial Actions Overconfidence in forecasting skills Overconfidence (encouraged by complex models), representativeness, availability, hindsight Prompt and accurate feedback, structure that rewards accuracy, learn to use Bayes’ formula Influence of company’s management on analysis Faming, anchoring and adjustment (analysis Disciplined and systematic influenced by initial default position or anchor), approach availability (greater importance to more easily available information) Analyst biases in conducting research Excessive unstructured information  illusion of knowledge  overconfidence Excessive information feeds representativeness bias (classify new information based on past experiences) Confirmation bias www.ift.world Focus on objective data, systematic and structured approach, follow Standard V, seek contrary facts and opinions Behavioral Factors and Investment Committees Social proof bias: Following the view points/decisions of a group Implications: • Group members become overconfident among themselves leading to excessive risk exposure • Group decisions are more vulnerable to confirmation bias • Group member avoids divergent opinions to avoid unpleasant tensions within a group Remedial Actions • Individual views should be collected before the meeting • Committee composition should have diversity in culture, knowledge, skills, experience and thought processes • Chair of the committee should be impartial • Committee members should respect opinions of each other • At least one member of a group should play a role of “devil’s advocate” www.ift.world Investor Behavior and Markets Observed Market Behavior Behavioral Explanation Momentum or trending effect Herding behavior Availability bias: more recent events easily recalled and given relatively high weight (recency effect) Hindsight bias  regret  trend-chasing effect Bubbles Overconfidence bias (illusion of knowledge and self attribution) leads to underestimation of risk and over-trading Crashes Disposition effect in the context of loss aversion bias: tendency to sell winners quickly and hold on to losers too long Value stocks outperform growth stocks in the longrun Halo effect: tendency of people to generalize positive views/beliefs about one characteristic of a product/person to another characteristic; related to representativeness bias refers to classifying new information based on past experiences www.ift.world ... www.ift.world Focus on objective data, systematic and structured approach, follow Standard V, seek contrary facts and opinions Behavioral Factors and Investment Committees Social proof bias: Following... is a passive investor www.ift.world Behavioral Investor Type Diagnostic Process How Behavioral Factors Affect Client-Adviser Relations Understanding client’s behavioral tendencies allows advisors... accounting • anchoring and adjustment • availability • hindsight • framing • • • • Investment advice • difficult to advise • explain effects of investment decisions on various investment goals •